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...show, small trade costs have large effects on many macroeconomic phenomena. There has also recently been an open debate on the contribution of geography and institutions to economic growth (see Gallup, Sachs, and Mellinger, 1998; and Acemoglu, Johnson, and Robinson, 2001) because geographical barriers naturally lead to higher transport costs. Furthermore, another branch of the economic growth literature has shown that macroeconomic volatility tends to have a negative impact on growth. (1)
These different literatures point to potentially strong linkages between trade costs and the macroeconomy. Yet there is still little rigorous work that examines the channels through which trade imperfections affect macroeconomic variables. In this paper, we provide a simple, intuitive model and empirical evidence, both of which allow us to analyze the impact of trade costs on the long-run volatility of a key macroeconomic variable: the real exchange rate. In particular, we incorporate Ricardian comparative advantage into a macroeconomic model to demonstrate that trade imperfections impact real exchange rate volatility.
The model shows how higher trade costs will lead to a greater range of non-tradable goods, thereby resulting in a country's having higher real exchange rate volatility. (2) Our model builds on the classic work of Dornbusch, Fischer, and Samuelson (1977). In particular, we incorporate uncertainty in the form of productivity shocks. We then present empirical results that support the model. Our result is based on the following intuition: in a Ricardian world without trade costs, productivity shocks will lead to changes in comparative advantage in producing goods across countries. However, the law of one price will continue to hold. Transport costs create a wedge between prices for some of the goods in which the domestic and foreign economies specialize. This wedge will result in the production in both economies of non-tradable goods, whose prices are independent of the other country's productivity shock. Therefore, given country shocks, relative prices of these goods will not equate across countries; and because a country's overall price index is made up of both tradable and non-tradable goods, the real exchange rate will move. Therefore, the higher the trade costs are (measured as iceberg costs; i.e., a constant fraction of the good melts away in transit), the higher the real exchange rate volatility will be.
We believe that this is a simple point that has not been fully explored in the literature. Indeed, our paper complements Hau's (2002) result that more open economies experience less real exchange rate volatility, although we highlight a different mechanism than he does. Hau shows that in an economy with nominal rigidities, imported goods provide a channel for a rapid adjustment of the domestic aggregate price level. (3) We, in turn, show that trade costs determine the size of the nontradables sector. In our model, a larger nontradables sector implies a greater level of heterogeneity in the diffusion of productivity shocks among different economies. Thus, our paper is related to trade costs (either tariffs or transport costs), whereas these trade imperfections play no explicit role in Hau's work. (4) Our work also differs from Hau's in that he assumes nominal rigidities and we do not, because we have a rigid productive structure that gives a fundamental role to productivity shocks and nontradables price adjustment in the long run. The crucial role of productivity shocks on the long-run real exchange rate has been recently supported by the work of Alexius (2005), who finds that when considering the relationship between fundamental variables and real exchange rates over the long run, productivity shocks play an important role in explaining real exchange rate movements. Finally, we note that our approach is complementary to the new open macroeconomics literature in that we focus on the study of long-run static relationships for a cross-section of countries rather than stochastic dynamic general equilibrium relationships.
Measuring the potential impact of our channel for a large cross-section of countries is not easy given data constraints. Therefore, our main measure is based on how close a country is to the center of world trade. We refer to this proxy of trade costs as "Remoteness." As can be seen in Figure 1, our proposed relationship appears to exist in the data, that is, countries that are more remote all exhibit greater real exchange rate volatility.
I. Two-Country Model
The model that we build provides a simple illustration of how increases in trade costs can increase real exchange rate volatility by creating a wedge between the tradables and nontradables sectors so that shocks do not transmit perfectly across countries. The model is set up in a two-country framework, but the foreign country represents the rest of the world. This distinction must be made because an individual country's range of nontradable goods depends on its trade costs with all of its potential trading partners. We also make this distinction in the empirical work by using a country's real effective exchange rate and proxying overall trade costs by a country's closeness to the world trade center. Furthermore, this model is meant to explain long-run real exchange rate volatility. The two-country model borrows heavily from Obstfeld and Rogoff (1996) and makes one central prediction: real exchange rate volatility increases with trade costs and, therefore, increases with the distance between one country and its trade partners around the world. We outline the model...
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